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Is someone offering to sell you a home on a contract for deed? Know the risks.

A contract for deed (sometimes called an installment purchase contract or installment sale agreement) is a real estate transaction in which the purchase of the property is financed by the seller rather than a third party such as a bank, credit union or other mortgage lender. It is often used when a buyer does not qualify for a conventional mortgage

Instead of purchasing a home with a mortgage, the buyer agrees to directly pay the seller in monthly installments. The buyer is able to occupy the home after the closing of the sale, but the seller still retains legal title to the property. Actual ownership passes to the buyer only after the final payment is made.

Contracts for deed have long been a financing option for property transactions between family members or friends. Some nonprofit housing organizations also use them to help low-income families find a path to homeownership.

But in the wake of the 2008 financial crisis, some real estate investment companies have bought up foreclosed homes and then offered them on contract for deed to low-income buyers or those with poor credit scores who cannot secure traditional mortgage financing.

Contracts for deed are also a favorite trick used by real estate scammers who will either “churn” a property through multiple would-be homebuyers or collect payments from a buyer while letting the property go into default with an unpaid mortgage.

While a contract for deed can sometimes benefit a buyer with no other avenue to homeownership, it is a high-risk option that is subject to abuse and predatory practices. It also lacks many of the consumer rights and protections available under state and federal laws for homebuyers who have traditional mortgages. If the buyer fails to make a payment or is in default on other conditions of the contract, the seller can cancel the contract, evict the buyer and quickly reclaim the property without a foreclosure sale or judicial action.

A contract for deed can appear simple and straightforward, but this financing option can pose a number of pitfalls for a homebuyer. Many buyers with contracts for deed never become full owners of the property and they lose all the payments they made toward ownership.

Before signing a contract for deed, prospective homebuyers should make sure they fully understand the extent of their obligations under the contract, all of the costs they will be responsible for and the risks they are incurring, including how quickly they can lose the home and all the payments they have made.

What You Need to Know

Here are some important considerations you should know about before buying a home on a contract for deed.

Full costs

Make sure you understand and can handle all of the costs you will be responsible for. In addition to monthly installment payments to the seller, you will have to pay for homeowners insurance, property taxes and repair and maintenance costs as specified in the contract for deed. Many contract for deed homes are sold “as is” and may need major repairs which become your responsibility. Depending on the terms of the contract, you could lose the home if you do not pay for repairs.

Balloon payment

As in a standard mortgage, a contract for deed typically has an agreed-upon price and payment schedule. But the payments are often not amortized evenly over a long period, meaning you will likely be required to make a large lump-sum “balloon payment” at a specific date to complete the purchase by covering the full balance due on the sale price. At that time, you will probably need to get a mortgage for the balloon payment. If you are unable to qualify for a mortgage or otherwise make the balloon payment when it is due, you will likely face cancellation of the contract and eviction.

Cancellation and eviction

If you miss just a single payment, or cannot make the balloon payment or do not fulfill any other provisions in the contract for deed, the seller can cancel the contract and begin an eviction action against you in just 60 days. You will lose the home and all the money you have already paid toward ownership of it.

Mortgage and property liens

Because a seller retains the title to the property during the life of the contract, you run the risk that the seller could encumber the property with mortgages and liens. If the seller does not make mortgage payments and the property goes into foreclosure, you will lose the home.

Recording the contract for deed

Within four months of signing the contract for deed, you must “record” it with the office of the county recorder or registrar of titles in the county in which the property is located. If you do not do so, you could face a fine. Recording the contract will also help prove your possession of the property and protect you from post-contract encumbrances placed on the property by the seller.

Important Tips

Here are some important tips if you are considering buying a home with a contract for deed.

Apply for a conventional mortgage

Instead of jumping at a risky seller-financed offer, you should first try to qualify for a conventional mortgage loan from a bank, credit union or other licensed mortgage lender. It will include more consumer protections and likely cost you less.

Get advice

A contract for deed is a complex arrangement with many legal and financial risks. Consult with a lawyer or a certified housing counselor so you understand the pros and cons of a contract for deed in your situation.

Get an independent appraisal and a professional inspection

An appraisal will tell you how much the property is worth so you do not overpay. An inspection will tell you about the property’s condition and what repairs are needed. Also check with the local housing inspection office about any reported code violations that require repairs.

Make sure you understand the contract and your financial responsibilities

Review the monthly payment, property tax, insurance and maintenance/repair requirements you are accepting. What interest rate are you paying? How much is the balloon payment and when is it due? What are the terms under which the seller can cancel the contract and evict you?

Research the property title

Make sure the seller really owns the property. You risk losing the home and everything you have paid if it has a mortgage and goes into foreclosure. Check with a title agent or the county property office to find out if there is a mortgage or other liens on the property. A title agent can also ensure the contract is properly recorded with the county, as required by state law. This will also help prove your possession of the property and protect you from post-contract encumbrances placed on the property by the seller.